Federal Reserve’s Tantrum and its spillover effect on India

The Federal Open Market Committee (FOMC) concluded its much awaited 2-day meeting on 26th January 2022. Taking a hawkish stand, the Fed Chair Jerome Powell has said that the Central Bank was preparing to raise the federal funds rate in March’22. However, he did not rule out further upward rate revision in future. The Fed has taken this hawkish stand to fight consumer inflation in the US which is already more than 7%- most since the 1980s. The Fed also signaled the end of its asset purchase program, though a specific timeline was not shared. Even though asset markets worldwide had already factored in at least four rate hikes in this calendar year, they tumbled after the Fed’s announcement.

The Fed’s policy move along with increasing energy prices worldwide due the NATO-Russia standoff in Ukraine will have huge ramifications for the Indian economy. Some of them are listed below: –

1. The most immediate impact is being felt in the Indian equity market as it has already corrected for more than 6% in the last week. The portfolio investors are pulling the money from emerging markets. India is at higher risk given its expensive valuation. Despite steep corrections, it is one of the most expensive markets with a trailing price to earning (P/E) multiple of 26.3x which is nearly twice the MSCI emerging market’s P/E of 13.9x.
2. Growth investment which was much hyped in the last decade will see a lot of churn. This investment strategy was dependent on cheap money from the central banks post 2008 financial crisis, and as the Fed starts tightening the policy rate growth, investors are bound to burn their hands. On the contrary, old value investors who had been sneered at over the past decade will come back with vengeance.
3. Emerging market investment portfolios may shrink as these markets are considered speculative, and given the increase in interest rates in developed countries, investors may prefer to invest in there. Foreign portfolio investors have already withdrawn more than US $ 8 billion from key emerging markets including India, South Korea and Taiwan.
4. If the share market remains depressed, the Indian government will find it difficult to list Life Insurance Corporation (LIC) at a favorable price. This in turn will adversely affect the government divestment target for the next financial year.
5. With the flight of capital from India, Rupee will come under pressure and will depreciate further unless the Reserve Bank of India (RBI) intervenes in the exchange market. However, if the RBI intervenes to support Rupee, liquidity will increase further in the economy which will put inflationary pressure. If the RBI sells government bonds to absorb excess liquidity, it will raise bond yield.
6. Government borrowing in India will become costly as bond yields will increase. This will adversely affect the economic growth since the economy at present is primarily dependent on government expenditure for growth.